Equity Premium Survey Doesn't Register My Vote

Pablo Fernandez has made it his job to survey finance professionals to see what they all think the 'equity risk premium' should be. This is the expected annualized return one expects on equities over the 'risk free' rate, and is used for various cost-of-funding assumptions. In his recent survey most put it currently about 5.5%, 3% below the number from textbooks around 1990.

But here's something funny. Someone told me they responded to his annual survey with 0%, as I argued in my book, noting that with geometric averaging, survivorship bias to the US experience, taxes, transaction costs, and adverse timing, your average investor is at the discount rate Warren Buffet uses: Long Term Treasuries. This observation was not included in his survey because it was too extreme!

Now, I can see removing observations that appear mistakes, but 0% isn't crazy, just low. Ivo Welch is a pretty conventional finance professor, has new finance textbook (available free online here), and he argues that it is between 2 and 4%. Eugene Fama and Ken French argue it's around 3.5%. Dimson, Marsh and Staunton, 3.5%. These professors, meanwhile, are ahead of the professionals who naturally remember what they learned in business school, which for your average respondent was around 1990. So, I'm below the current estimate of orthodox and highly esteemed economists by about 3.5%, which is less than these guys are below the conventional wisdom circa 1990. Just looking at how this datum has moved, suggests my estimate is plausible. Forecast errors are not like lightening strikes in that they are more likely if they happened previously, not less, meaning, if the conventional wisdom has changed from 8.5% to 3.5%, it can go to zero.

This is why I like reading about science and epistemology in general because it's all well and good to say science is all about the evidence and people being 'reality based', and only idiots or bigots are prejudiced. Everyone only sees what they believe, and beliefs are not easily moved by contrary data: observations are theory-laden. The experts do not sees a risk premium below 2% because it just doesn't fit in their theoretical understanding of how things should be. To those who say that equities must generate a risk premium, otherwise no one would invest there, I would say that we don't pay premiums for 'smelliness' or other kinds of unpleasantness. That is, Lord Keynes wrote on page 162 of his General Theory:

For example, smelly processes command a higher reward, because people will not undertake them otherwise. So do risky processes.

As usual he didn't actually look at the data and instead just threw out a plausible assertion, because toilet cleaners do not earn more than other custodians, and the untouchables of India who monopolize sewage work are not compensated well at all. Further, we don't earn extra for the following: IPOs, penny stocks, options, long duration bonds, junk bonds, long-short sports bets, lottery tickets, volatility within the stock market, currencies, and commodities, just to name a few, so why should stocks be different?

Don't expect to make more money for taking risk, just know you have to take risk to make more money. If you don't understand the difference, you shouldn't be taking risk.